Analyzing International Relations and American Politics

The Myth of the Perfect Currency Union

As you might have guessed, I have been following the Brexit vote very closely over these past few days. One of the central grievances driving voters to the Leave camp is the dysfunctional E.U. I certainly understand this. After all, while I’m not exactly a Euro-skeptic, I find the E.U. to be a deeply flawed, inefficient, and undemocratic organization. Its institutions are complex beyond belief and its economic linkages are insufficient. That being said, I don’t buy the argument that Europe is inherently incapable of existing in a currency union.

Just trying to understand how all the different governing bodies fit together is migraine-inducing

There has recently been much discussion and debate over the economic underpinnings of the E.U. From 2008 post mortems to Brits weighing the costs and benefits of dropping the Pound, the Euro question has been analyzed ad nauseam. Currency unions are an interesting economic idea, and they are certainly not without controversy. One argument many people make against the single currency is that it fails to allow countries to set interest rates and inflation levels individually, preventing fine-grained economic tuning. These analysts argue that Germany and Spain, for example, possess very different markets with different business cycles, and it therefore makes very little sense for them to utilize the same monetary policy.

It’s also important to realize that exchange rates and monetary policy aren’t the only tools available to policy makers. Stimulus spending, tax breaks, and regulatory policy are other powerful instruments with which governments can influence their economies. Furthermore, as Schelkle goes on to point out, it’s far from clear that exchange rates are even effective tools at combating economic malaise.

Exchange rates have proven to be completely unreliable adjustment mechanisms for the real economy. They are determined by markets for financial assets, not the needs of labour markets or the trade balance. Or else the US dollar should have devalued much more than it did against the euro so as to correct the stubborn current account deficit. Instead, at the height of the financial crisis in 2008 that had started in the US, capital flows streamed into US Treasury bonds as a safe haven. Optimal currency area theory ignores financial markets completely, along with monetary policy and central banks. Quite curious for a theory about monetary integration. Maybe this a clue to why the Euro-architects did not find the theory all that helpful?

The E.U. absolutely must improve its economic system. For instance, there needs to be a much more integrated fiscal system in which wealthy states give economic transfers to more economically stagnant ones (much like the U.S. model). Moreover, the E.C.B. needs to be reformed so as to act as a lender of last resort, and there must be better cooperation and coordination over economic activities. That being said, it’s important to recognize that the Euro is not the problem. Instead, it is the lack of effective institutions that is currently retarding European economic growth. Instead of throwing out the entire system, Europe simply needs to reform it.